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The Market Is Misreading the Fed, Again

Forty-five words that make all the difference.

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

The way the month of August has been going, who could expect yesterday's stock market gains to last? The S&P 500(SNPINDEX:^GSPC) fell 0.6% today, while the narrower, price-weighted Dow Jones Industrial Average(DJINDICES:^DJI) was down 0.7%. The S&P 500 has produced only five winning days this month out of 15, and the Dow has only managed four!

Today's losses and price action were enough to lift the CBOE Volatility Index (VIX)(VOLATILITYINDICES:^VIX), Wall Street's "fear index," 6.9% to close at 15.94. After bottoming out at 11.84 on August 5, the VIX is finally returning to more reasonable levels. (The VIX is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days.) For context, the August 5 closing value was in the bottom 8% of the entire VIX daily price series going back to January 1990. By contrast, today's is roughly at the cutoff for the bottom third.

Today's Fed-watching excursionThe focus today was on the Fed, which released the minutes of its July FOMC policy meeting. The Federal Open Market Committee sets monetary policy in the U.S., which includes unconventional measures such as the Fed's monthly bond-buying spree (known as quantitative easing or QE.)

Traders and other impatient money types were looking for the smallest clue regarding when the Fed will start to reduce or "taper" its monthly asset purchases, but there wasn't all that much to gnaw on. As one might have expected, these minutes were broadly consistent with those from the June meeting. Still, I found the following passage noteworthy [emphasis mine]:

In considering the likely path for the Committee's asset purchases, members discussed the degree of improvement in the labor market outlook since the purchase program began last fall. The unemployment rate had declined considerably since then, and recent gains in payroll employment had been solid. However, other measures of labor utilization--including the labor force participation rate and the numbers of discouraged workers and those working part time for economic reasons--suggested more modest improvement, and other indicators of labor demand, such as rates of hiring and quits, remained low.

The June meeting minutes did not refer to "other measures of labor utilization" in the discussion of the "taper," and this mention suggests policymakers may be more reluctant to taper soon than previously believed. In light of mitigated data on the job front, they may feel the risks of an early withdrawal outweigh those associated with continuing the Fed's bond purchases at the current pace a little longer.

My sense, based on a massive daily diet of financial and economic media, is that the market consensus view is that tapering will begin next month. (Unfortunately, I could not find a prediction market for this question that might support this opinion.) However, I think the odds that the taper begins later than that are higher than the market currently anticipates. Roll on the "liquidity rally"!